Terms to fit your price

Thinking of selling your business or buying someone else’s? Many times there can be a large gap between what a seller is willing to accept and and what a buyer is willing to pay. This price gap can be bridged with creative deal terms in the purchase agreement. Some common deal terms that can close the price gap are discussed below.

Earnouts

An earnout withholds a portion of the sales price to ensure predetermined financial benchmarks are achieved. This allows an optimistic seller to “earn” a higher selling price by bearing some risk that the business will perform as represented. Earnouts also lower the buyer’s risk of overpaying for a company that doesn’t live up to seller representations. Earnout payments are typically held in an escrow account or paid from future operating cash flow.

However, earnouts may have drawbacks that should be considered up front. The parties may disagree on how to verify that financial targets were met. Earnouts also bring complicated tax issues to the negotiating table. Since earnout payments can be considered compensation for services or as sales proceeds, the buyer and seller have competing interests.

  • Earnout payments treated as compensation

    The seller reports payments as ordinary income, which is taxed at a higher rate than capital gains. The seller also owes employee payroll taxes on the income. The buyer can deduct this compensation as a business expense, but will be responsible for employer payroll taxes.

  • Earnout payments treated as sales proceeds
    The seller may qualify for capital gains treatment, which are typically taxed at a lower rate than ordinary income. The the buyer receives an increased tax basis in their investment.

If earnout payments are not made before year end, more complex tax rule may be triggered. These rules differ depending on whether there’s a determinable maximum selling price or a fixed payment period.

Asset Sales
Buyers often prefer asset sales and select specific assets to acquire. From a tax perspective, buyers benefit from a stepped-up basis for depreciable assets acquired. Sellers generally owe more tax in an asset sale.

Asset sales protect buyers from inheriting contingent liabilities, such as product claims and employee-related lawsuits. However, intellectual property, contracts, leases, and goodwill may be difficult to transfer in asset sales.

Stock Sales
Sellers generally prefer stock sales for tax purposes as they usually result in lower taxes on sale. Buyers do not get a stepped up basis for depreciable assets and are subject to the existing depreciation schedule.

The buyer acquires an equity interest in the company, forcing the seller to either divest unwanted assets and liabilities before closing or adjust the sale price. Assets that are hard to transfer will automatically flow to the buyer, along with contingent liabilities.

Installment sales

If the installment sale method is used to report the sale, sellers can recognize profits and tax gains proportionately over time for eligible property. The buyer also receives a fully stepped-up basis in acquired property. This allows the buyer to take depreciation deductions based on the purchase price without paying the full amount wasn’t exchanged at closing.

Installment sales can get deals done when buyers have limited access to bank financing. Essentially, sellers finance the deal. While advantageous for the buyer, the seller bears default risk in the transaction.

The seller also bears risk in future tax policies. Increasing tax rates are detrimental to the seller as they reduce net proceeds. However, there is some upside potential if tax rates decrease in the future. In addition, depreciation recapture must be reported as a gain in the year of the sale. This applies even when it exceeds the installment payment the seller received in that year.

Not all transactions are eligible for the installment method. For example, inventory sales and transactions involving related parties are ineligible.

Consulting and noncompetes

After closing, sellers can facilitate management changes as an employee or consultant. This continuity can reduce turnover, minimize disruptions, and build trust with long-term employees, suppliers, and customers.

It is possible for sellers use their business contacts and specialized knowledge to compete with the business they just exited. To avoid this, buyers should consider adding restrictive covenants, such as noncompetes or nonsolicitation provisions, to the purchase agreement. These restrictive covenants prevent sellers from:

  • Diverting business opportunities from the company

  • Working for competitors within a defined geographic area

  • Soliciting the company’s employees to work for the seller or any affiliates

The parties should negotiate the purchase price allocation for consulting agreements and restrictive covenants. These allocations have tax and financial reporting consequences that must be considered.

Negotiating an optimal deal structure takes time, patience, and financial knowledge. A valuation specialist can help you understand the financial implications of creative deal terms.

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We can help walk you through them impact of a multitude of deal term options to help you close the deal at the right price.

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